Archive for the Chinese Economy Category

Most countries worry about brain drain. China is worried about millionaire drain.

A new report in China shows that 150,000 Chinese – most of them wealthy – emigrated to other countries in 2011. While that number may not seem high for a country of more than a billion people, the flight of China’s richest – and the offshoring of their fortunes – could cost the country jobs and economic growth, according to the study from the Center for China and Globalization and the Beijing Institute of Technology.

“The private economy contributes more than 60 percent of China’s GDP and it absorbs a majority of employees. So if private business owners emigrate with their capital, it would mean less investment in the domestic market, so fewer jobs would be created,” Wang Huiyao, director of the Center for China and Globalization, told the state-run China Daily today.

The fleeing millionaires mainly made their money in real estate, foreign currency and deposits and stocks, among other fields, according to the report. They are mainly leaving Beijing, Shanghai and coastal provinces such as Zhejiang, Guangdong and Jiangsu. (Read more: BRICs Outpace U.S. in Millionaires)

The Chinese government has struggled to stem the tide of wealthy Chinese moving abroad or tunneling their fortunes out of the country. Last month, Zhang Lan – the founder of the South Beauty restaurant chain and a powerful political player – emigrated to an unknown foreign country. She had previously been an outspoken critic of rich Chinese who moved abroad.

When asked about her reasons for moving, her spokesman told China Daily, “It’s a private issue.”

Officially, Chinese individuals are allowed to move only $50,000 offshore every year. But many Chinese have been skirting the rules and moving money to overseas accounts, or buying property, art, wine and other assets overseas.

The Wall Street Journal recently estimated that more than $225 billion flowed out of China in the 12 months ended in September. (Read more: What Do Wealthy Chinese Women Want?)

The report on emigration said that for Chinese moving abroad, the main reasons cited for leaving are the security of their assets, improved quality of life and better education for their kids.

China’s wealth flight, however, has been America’s gain. The United States was the top destination for wealthy Chinese in 2011, according to the report. Canada and Australia came second and third.

The report said that the United States had granted 87,000 permanent resident permits to Chinese nationals in 2011. Of those, 3,340 were approved through special investment visas, which allows wealthy foreigners to apply for American citizenship if they agree to invest more than $500,000 on job-creation projects. The program has become largely Chinese, with more than more than two thirds of all of the visas granted going wealthy citizens of mainland.

Last year, for the first time, more patent applications were filed in China than in the United States. This surge reflects China’s increasing intellectual property maturity and growing pains, according to U.S. Intellectual property lawyers and experts.

Worldwide patent filings exceeded the 2 million mark, with 2.14 million filed last year. That’s a 7.8 percent boost over the 1.99 million applications filed in 2010.

“Sustained growth in IP filings indicates that companies continue to innovate despite weak economic conditions. This is good news, as it lays the foundation for the world economy to generate growth and prosperity in the future,” said WIPO director general Francis Gurry at a press conference in Geneva.

The numbers reflect a boost in innovation by Chinese nationals, said Stuart Meyer, an intellectual property partner at Fenwick & West in Mountain View, Calif. It’s not just U.S. inventors wanting to get protection in China because it’s commercially important, he said. “That’s a real sea change.”

Ultimately, such filing shifts could affect U.S. patent policy, which offers great protections for intellectual property producers, he said.

The balance is shifting a little bit because more U.S. companies are dealing with licensing intellectual property owned by foreign patentees, said Meyer. “We’re the ones that don’t need such rigorous protection because we’re on the other side of the coin. It changes the way we’re going to be thinking about this in the coming decades.”

The numbers are a milestone in the way innovation is distributed around the world, said Q. Todd Dickinson, executive director of the American Intellectual Property Law Association. “Clearly china is in growth mode in terms of research and development and patent filings track that closely.”

He also said China’s intellectual property system is maturing. “Clearly they’re using IP to protect indigenous innovation.”

The filings show that everyone wants to do business in China, but China also needs to improve patent enforcement, said Peter Toren, a partner at Weisbrod Matteis & Copley in Washington.

“I’ll be more impressed when I get the real sense that China is enforcing patent rights…I want to see them allowing companies to really enforce the rights they have,” Toren said.

Dynamic domestic players and focused multinationals are helping China churn out a growing number of innovative products and services. Intensifying competition lies ahead; here’s a road map for navigating it.

MCKINSEY QUARTERLY FEBRUARY 2012 • Gordon Orr and Erik Roth

China is innovating. Some of its achievements are visible: a doubling of the global percentage of patents granted to Chinese inventors since 2005, for example, and the growing role of Chinese companies in the wind- and solar-power industries. Other developments—such as advances by local companies in domestically oriented consumer electronics, instant messaging, and online gaming—may well be escaping the notice of executives who aren’t on the ground in China.

As innovation gains steam there, the stakes are rising for domestic and multinational companies alike. Prowess in innovation will not only become an increasingly important differentiator inside China but should also yield ideas and products that become serious competitors on the international stage.

Chinese companies and multinationals bring different strengths and weaknesses to this competition. The Chinese have traditionally had a bias toward innovation through commercialization—they are more comfortable than many Western companies are with putting a new product or service into the market quickly and improving its performance through subsequent generations. It is common for products to launch in a fraction of the time that it would take in more developed markets. While the quality of these early versions may be variable, subsequent ones improve rapidly.1

Chinese companies also benefit from their government’s emphasis on indigenous innovation, underlined in the latest five-year plan. Chinese authorities view innovation as critical both to the domestic economy’s long-term health and to the global competitiveness of Chinese companies. China has already created the seeds of 22 Silicon Valley–like innovation hubs within the life sciences and biotech industries. In semiconductors, the government has been consolidating innovation clusters to create centers of manufacturing excellence.

But progress isn’t uniform across industries, and innovation capabilities vary significantly: several basic skills are at best nascent within a typical Chinese enterprise. Pain points include an absence of advanced techniques for understanding—analytically, not just intuitively—what customers really want, corporate cultures that don’t support risk taking, and a scarcity of the sort of internal collaboration that’s essential for developing new ideas.

Multinationals are far stronger in these areas but face other challenges, such as high attrition among talented Chinese nationals that can slow efforts to create local innovation centers. Indeed, the contrasting capabilities of domestic and multinational players, along with the still-unsettled state of intellectual-property protection (see sidebar, “Improving the patent process”), create the potential for topsy-turvy competition, creative partnerships, and rapid change. This article seeks to lay out the current landscape for would-be innovators and to describe some of the priorities for domestic and multinational companies that hope to thrive in it.

China’s innovation landscape

Considerable innovation is occurring in China in both the business-to-consumer and business-to-business sectors. Although breakthroughs in either space generally go unrecognized by the broader global public, many multinational B2B competitors are acutely aware of the innovative strides the Chinese are making in sectors such as communications equipment and alternative energy. Interestingly, even as multinationals struggle to cope with Chinese innovation in some areas, they seem to be holding their own in others.

The business-to-consumer visibility gap

When European and US consumers think about what China makes, they reflexively turn to basic items such as textiles and toys, not necessarily the most innovative products and rarely associated with brand names.

In fact, though, much product innovation in China stays there. A visit to a shop of the Suning Appliance chain, the large Chinese consumer electronics retailer, is telling. There, you might find an Android-enabled television complete with an integrated Internet-browsing capability and preloaded apps that take users straight to some of the most popular Chinese Web sites and digital movie-streaming services. Even the picture quality and industrial design are comparable to those of high-end televisions from South Korean competitors.

We observe the same home-grown innovation in business models. Look, for example, at the online sector, especially Tencent’s QQ instant-messaging service and the Sina Corporation’s microblog, Weibo. These models, unique to China, are generating revenue and growing in ways that have not been duplicated anywhere in the world. QQ’s low, flat-rate pricing and active marketplace for online games generate tremendous value from hundreds of millions of Chinese users.

What’s keeping innovative products and business models confined to China? In general, its market is so large that domestic companies have little incentive to adapt successful products for sale abroad. In many cases, the skills and capabilities of these companies are oriented toward the domestic market, so even if they want to expand globally, they face high hurdles. Many senior executives, for example, are uncomfortable doing business outside their own geography and language. Furthermore, the success of many Chinese models depends on local resources—for example, lower-cost labor, inexpensive land, and access to capital or intellectual property—that are difficult to replicate elsewhere. Take the case of mobile handsets: most Chinese manufacturers would be subject to significant intellectual property–driven licensing fees if they sold their products outside China.

Successes in business to business

Several Chinese B2B sectors are establishing a track record of innovation domestically and globally. The Chinese communications equipment industry, for instance, is a peer of developed-world companies in quality. Market acceptance has expanded well beyond the historical presence in emerging markets to include Europe’s most demanding customers, such as France Télécom and Vodafone.

Pharmaceuticals are another area where China has made big strides. In the 1980s and 1990s, the country was a bit player in the discovery of new chemical entities. By the next decade, however, China’s sophistication had grown dramatically. More than 20 chemical compounds discovered and developed in China are currently undergoing clinical trials.

China’s solar- and wind-power industries are also taking center stage. The country will become the world’s largest market for renewable-energy technology, and it already has some of the sector’s biggest companies, providing critical components for the industry globally. Chinese companies not only enjoy scale advantages but also, in the case of solar, use new manufacturing techniques to improve the efficiency of solar panels.

Success in B2B innovation has benefited greatly from friendly government policies, such as establishing market access barriers; influencing the nature of cross-border collaborations by setting intellectual-property requirements in electric vehicles, high-speed trains, and other segments; and creating domestic-purchasing policies that favor Chinese-made goods and services. Many view these policies as loading the dice in favor of Chinese companies, but multinationals should be prepared for their continued enforcement.

Despite recent setbacks, an interesting example of how the Chinese government has moved to build an industry comes from high-speed rail. Before 2004, China’s efforts to develop it had limited success. Since then, a mix of two policies—encouraging technology transfer from multinationals (in return for market access) and a coordinated R&D-investment effort—has helped China Railways’ high-speed trains to dominate the local industry. The multinationals’ revenue in this sector has remained largely unchanged since the early 2000s.

But it is too simplistic to claim that government support is the only reason China has had some B2B success. The strength of the country’s scientific and technical talent is growing, and local companies increasingly bring real capabilities to the table. What’s more, a number of government-supported innovation efforts have not been successful. Some notable examples include attempts to develop an indigenous 3G telecommunications protocol called TDS-CDMA and to replace the global Wi-Fi standard with a China-only Internet security protocol, WAPI.

Advantage, multinationals?

Simultaneously, multinationals have been shaping China’s innovation landscape by leveraging global assets. Consider, for example, the joint venture between General Motors and the Shanghai Automotive Industry Corporation, which adapted a US minivan (Buick’s GL8) for use in the Chinese market and more recently introduced a version developed in China, for China. The model has proved hugely popular among executives.

In fact, the market for vehicles powered by internal-combustion engines remains dominated by multinationals, despite significant incentives and encouragement from the Chinese government, which had hoped that some domestic automakers would emerge as leaders by now. The continued strength of multinationals indicates how hard it is to break through in industries with 40 or 50 years of intellectual capital. Transferring the skills needed to design and manufacture complex engineering systems has proved a significant challenge requiring mentorship, the right culture, and time.

We are seeing the emergence of similar challenges in electric vehicles, where early indications suggest that the balance is swinging toward the multinationals because of superior product quality. By relying less on purely indigenous innovation, China is trying to make sure the electric-vehicle story has an ending different from that of its telecommunications protocol efforts. The government’s stated aspiration of having more than five million plug-in hybrid and battery electric vehicles on the road by 2020 is heavily supported by a mix of extensive subsidies and tax incentives for local companies, combined with strict market access rules for foreign companies and the creation of new revenue pools through government and public fleet-purchase programs. But the subsidies and incentives may not be enough to overcome the technical challenges of learning to build these vehicles, particularly if multinationals decline to invest with local companies.

Four priorities for innovators in China

There’s no magic formula for innovation—and that goes doubly for China, where the challenges and opportunities facing domestic and multinational players are so different. Some of the priorities we describe here, such as instilling a culture of risk taking and learning, are more pressing for Chinese companies. Others, such as retaining local talent, may be harder for multinationals. Collectively, these priorities include some of the critical variables that will influence which companies lead China’s innovation revolution and how far it goes.

Deeply understanding Chinese customers

Alibaba’s Web-based trading platform, Taobao, is a great example of a product that emerged from deep insights into how customers were underserved and their inability to connect with suppliers, as well as a sophisticated understanding of the Chinese banking system. This dominant marketplace enables thousands of Chinese manufacturers to find and transact with potential customers directly. What looks like a straightforward eBay-like trading platform actually embeds numerous significant innovations to support these transactions, such as an ability to facilitate electronic fund transfers and to account for idiosyncrasies in the national banking system. Taobao wouldn’t have happened without Alibaba’s deep, analytically driven understanding of customers.

Few Chinese companies have the systematic ability to develop a deep understanding of customers’ problems. Domestic players have traditionally had a manufacturing-led focus on reapplying existing business models to deliver products for fast-growing markets. These “push” models will find it increasingly hard to unlock pockets of profitable growth. Shifting from delivery to creation requires more local research and development, as well as the nurturing of more market-driven organizations that can combine insights into detailed Chinese customer preferences with a clear sense of how the local business environment is evolving. Requirements include both research techniques relevant to China and people with the experience to draw out actionable customer insights.

Many multinationals have these capabilities, but unless they have been operating in China for some years, they may well lack the domestic-market knowledge or relationships needed to apply them effectively. The solution—building a true domestic Chinese presence rather than an outpost—sounds obvious, but it’s difficult to carry out without commitment from the top. Too many companies fail by using “fly over” management. But some multinationals appear to be investing the necessary resources; for example, we recently met (separately) with top executives of two big industrial companies who were being transferred from the West to run global R&D organizations from Shanghai. The idea is to be closer to Chinese customers and the network of institutions and universities from which multinationals source talent.

Retaining local talent

China’s universities graduate more than 10,000 science PhDs each year, and increasing numbers of Chinese scientists working overseas are returning home. Multinationals in particular are struggling to tap this inflow of researchers and managers. A recent survey by the executive-recruiting firm Heidrick & Struggles found that 77 percent of the senior executives from multinational companies responding say they have difficulty attracting managers in China, while 91 percent regard employee turnover as their top talent challenge.

Retention is more of an issue for multinationals than for domestic companies, but as big foreign players raise their game, so must local ones. Chinese companies, for example, excel at creating a community-like environment to build loyalty to the institution. That helps keep some employees in place when competing offers arise, but it may not always be enough.

Talented Chinese employees increasingly recognize the benefits of being associated with a well-known foreign brand and like the mentorship and training that foreign companies can provide. So multinationals that commit themselves to developing meaningful career paths for Chinese employees should have a chance in the growing fight with their Chinese competitors for R&D talent. Initiatives might include in-house training courses or apprenticeship programs, perhaps with local universities. General Motors sponsors projects in which professors and engineering departments at leading universities research issues of interest to the automaker. That helps it to develop closer relations with the institutions from which it recruits and to train students before they graduate.

Some multinationals energize Chinese engineers by shifting their roles from serving as capacity in a support of existing global programs to contributing significantly to new innovation thrusts, often aimed at the local market. This approach, increasingly common in the pharma industry, may hold lessons for other kinds of multinationals that have established R&D or innovation centers in China in recent years (read about AstraZeneca’s experience in “Three snapshots of Chinese innovation”). The keys to success include a clear objective— for instance, will activity support global programs or develop China-for-China innovations?—and a clear plan for attracting and retaining the talent needed to staff such centers. Too often, we visit impressive R&D facilities, stocked with the latest equipment, that are almost empty because staffing them has proved difficult.

Instilling a culture of risk taking

Failure is a required element of innovation, but it isn’t the norm in China, where a culture of obedience and adherence to rules prevails in most companies. Breaking or even bending them is not expected and rarely tolerated. To combat these attitudes, companies must find ways to make initiative taking more acceptable and better rewarded.

One approach we found, in a leading solar company, was to transfer risk from individual innovators to teams. Shared accountability and community support made increased risk taking and experimentation safer. The company has used these “innovation work groups” to develop everything from more efficient battery technology to new manufacturing processes. Team-based approaches also have proved effective for some multinationals trying to stimulate initiative taking (read about General Motors’ approach in “Three snapshots of Chinese innovation”).

How fast a culture of innovation takes off varies by industry. We see a much more rapid evolution toward the approach of Western companies in the way Chinese high-tech enterprises learn from their customers and how they apply that learning to create new products made for China (read a perspective on the evolution of its semiconductor sector in “Thee snapshots of Chinese innovation”). That approach is much less common at state-owned enterprises, since they are held back by hierarchical, benchmark-driven cultures.

Promoting collaboration

One area where multinationals currently have an edge is promoting collaboration and the internal collision of ideas, which can yield surprising new insights and business opportunities. In many Chinese companies, traditional organizational and cultural barriers inhibit such exchanges.

Although a lot of these companies have become more professional and adept at delivering products in large volumes, their ability to scale up an organization that can work collaboratively has not kept pace. Their rigorous, linear processes for bringing new products to market ensure rapid commercialization but create too many hand-offs where insights are lost and trade-offs for efficiency are promoted.

One Chinese consumer electronics company has repeatedly tried to improve the way it innovates. Senior management has called for new ideas and sponsored efforts to create new best-in-class processes, while junior engineers have designed high-quality prototypes. Yet the end result continues to be largely undifferentiated, incremental improvements. The biggest reason appears to be a lack of cross-company collaboration and a reliance on processes designed to build and reinforce scale in manufacturing. In effect, the technical and commercial sides of the business don’t cooperate in a way that would allow some potentially winning ideas to reach the market. As Chinese organizations mature, stories like this one may become rarer.

China hasn’t yet experienced a true innovation revolution. It will need time to evolve from a country of incremental innovation based on technology transfers to one where breakthrough innovation is common. The government will play a powerful role in that process, but ultimately it will be the actions of domestic companies and multinationals that dictate the pace of change—and determine who leads it.

All eyes are on China this November as the country prepares for the once in a decade leadership transition within the ruling Communist Party.

The world’s second biggest economy has undergone a massive transformation within the last 10 years. From rapid urbanization and economic growth to social and political development, China has marked many milestones and firsts in the past decade — highlighting its significance on the global stage.

With this in mind, we look at six major changes that China has undergone since the last leadership transition in 2002. Focusing on factors like economic development to changes in consumer behavior, we look at how big of an impact China’s transformation has had on the rest of the world.

Riding the wave of rapid economic expansion, China’s growth engine has remained strong over the past decade. China’s economy grew from being the 5th largest in the world in 2002 to 2nd only to the U.S. by 2010.

The country has seen an average annual gross domestic product (GDP) growth of 10.6 percent since the last leadership transition in November 2002. Yearly economic growth was in the double digits from 2003 to 2007 and hit a high of 14.2 percent in 2007 — levels not seen since the early 1990s. However, like the rest of the world, China was impacted by the global financial crisis in 2008 and saw its GDP fall to 9.6 percent that year. Since then, the superpower has been able to maintain strong economic growth of over 9 percent, but it continues to be plagued by fears of a hard landing. GDP in the second quarter of this year fell to 7.6 percent, hitting its slowest pace in three years.

Many economists now expect China’s annual GDP to fall below 8 percent in 2012, with even Beijing setting a target of 7.5 percent growth — marking China’s first drop to that level since 1999. Uncertainty over how the new leadership will deal with slowing growth is intensifying and several analysts have told CNBC that policymakers may be taking their eye off the ball when it comes to the economy to prepare for the once-a-decade leadership transition. The politics involved in the government change may be slowing the policymaking in China and deterring the government from making significant economic decisions, according to experts.

Rising incomes

National Bureau of Statistics China

Economic development has led to rising incomes in China as workers demand higher wages to cope with soaring living costs in major cities.

In a 10 year period, the per capita income of urban residents rose from $827 in 2001 to $3,711 in 2011, according to the National Bureau of Statistics of China. That’s a nearly 350 percent increase. China’s average minimum wage has been rising an average 12.5 percent annually from 2006 to 2010, and the government announced earlier this year that minimum wages should grow by an average of at least 13 percent in the five years to 2015.

Rising wages has become a major concern for local and international manufacturers betting on “cheap” Chinese labor for growth. Many are moving production inland to save on costs, while others are looking into alternative manufacturing hubs in Asia like Vietnam, the Philippines and Indonesia. For example, Apple supplier Foxconn, in the news recently for labor unrest at its Chinese factories, announced in August that it would invest $10 billion in Indonesia to tap into one of the cheapest labor forces in Asia.

Stocks Outperform in a Decade

Thomson Reuters

China’s battered stock market, which was down more than 20 percent in 2011, and is lower by nearly 6 percent so far this year, has made headlines recently for being the worst performing major equity market in Asia — a sharp contrast to China’s growth story.

Still, taking into account the total gains made over the past decade paints a more bullish picture. The Shanghai Composite index rose 35 percent from 2002 to 2011, far outperforming the U.S. benchmark S&P 500 which only rose 9 percent in the same period. But, despite the substantial 10-year gain, it hasn’t been all smooth sailing for Chinese equities. The Shanghai Composite fell about 65 percent to 2,016 in October 2008 during the global financial crisis from a peak level of 5,725 in September 2007. While stocks continued to gain ground up until August 2009, it has been in a steady decline since.

Despite the downtrend in the last three years, several analysts are still optimistic about a turnaround in Chinese equities on the growing possibility of more easing by the government to spur growth. Japanese brokerage Nomura predicted in July that Chinese stocks could climb as much as 20 percent by the first quarter of 2013 after having bottomed in early June. Meanwhile, the notable head of Goldman Sachs Asset Management — Jim O’Neill — said in September that Chinese equities present the “most attractive” investment opportunity in all of the BRIC markets.

Internet Explosion

China Internet Network Information Center

By sheer numbers, China is experiencing a technology boom unlike anywhere else in the world. Its internet population surpassed half a billion users in 2011 — making it by far the world’s biggest online market. That’s a more than 362 percent increase since 2005. Even then, the internet usage penetration remained at 38 percent in 2011, presenting further growth potential.

About four out of 10 Chinese use the internet, accounting for a total of 538 million users, according to state-run agency China Internet Network Information Center (CNNIC). That population is set to jump to 700 million users by 2015, according to the Boston Consulting Group (BCG), which is more than double the entire population of the U.S. The country’s fast growing online market provides a big opportunity for retailers and BCG predicts that China’s online retail sales will triple to more than $360 billion by 2015 to make it the world’s largest online retail market.

Smartphone makers are also looking to increase their presence in the country’s mobile phone market. Nearly 70 percent of China’s internet users connected to the web through their handsets in 2011, according to the CNNIC.

Mega Rich Get Richer

The Hurun Research Institute

China’s billionaire count has surged in the past decade, spurred on by the country’s rapid economic development.

In 2001, China had only one billionaire, but that number has jumped to 251 this year —according to the Shanghai based Hurun Report — making it second only to the U.S. in the world when it comes to most billionaires. Billionaires account for just 1.3 percent of wealth individuals with $30 million or more in China, but control nearly a quarter of the ultra-rich group’s wealth of $1.58 trillion, according to research firm Wealth-X. These billionaires are worth an average of almost $2.6 billion each.

China’s consumption and construction boom are two of the major drivers of wealth for the super-rich with a majority of billionaires counting on property as one of their main sources of wealth. The public listing of companies has also made business owners billionaires overnight. But recently, the stock market has also caused China’s billionaires to lose almost a third of their combined wealth with the benchmark Shanghai Composite falling 20 percent from August 2011 to July 2012, according to Wealth-X. In total, the population of China’s wealthy with assets worth $30 million and above shrank by 2.3 percent in the past year, while their combined wealth decreased nearly 7 percent to $1.6 trillion.

Consumption Boom

National Bureau of Statistics China

Consumer spending in China has seen double digit growth for a decade, creating a path for the country to become the world’s biggest consumer market by 2015, according to government authorities.

Its fast growing consumer class of about 130 million has given a big boost to markets from retail and housing to travel and other discretionary sectors. China’s consumer retail sales, for example, are expected to surpass $5 trillion in 2015, according to Commerce Minister Chen Deming. Rising incomes amid rapid urbanization are major reasons behind China’s consumption boom and the World Bank expects the growth to continue as income per capita climbs to more than triple to $16,000 by 2030 from about $5,000 now.

Businesses like carmakers, luxury retailers, and hotel chains have been flocking to the world’s second largest economy to target Chinese consumers. Italian fashion house Prada, for example, counts on China as its biggest market with 30 percent of its global sales in the fiscal year that ended in January 2012 coming from the country. The luxury retailer has 19 stores in China, but plans to open up to 15 more this year. The world’s largest premium carmaker BMW, meanwhile, increased sales of its flagship BMW brand in China by 55 percent in September compared to the previous year, while its Mini cars saw sales jump a whopping 121 percent in the same period.

But not all retailers have had a similar level of success in China. Home Depot, the world’s largest home improvement chain, struggled to win over Chinese shoppers with its U.S. style do-it-yourself model. The U.S retailer announced in September that it will close all seven of its big box stores to focus on specialty stores and e-commerce in China.

Dynamic domestic players and focused multinationals are helping China churn out a growing number of innovative products and services. Intensifying competition lies ahead; here’s a road map for navigating it.

MCKINSEY QUARTERLY FEBRUARY 2012 • Gordon Orr and Erik Roth

China is innovating. Some of its achievements are visible: a doubling of the global percentage of patents granted to Chinese inventors since 2005, for example, and the growing role of Chinese companies in the wind- and solar-power industries. Other developments—such as advances by local companies in domestically oriented consumer electronics, instant messaging, and online gaming—may well be escaping the notice of executives who aren’t on the ground in China.

As innovation gains steam there, the stakes are rising for domestic and multinational companies alike. Prowess in innovation will not only become an increasingly important differentiator inside China but should also yield ideas and products that become serious competitors on the international stage.

Chinese companies and multinationals bring different strengths and weaknesses to this competition. The Chinese have traditionally had a bias toward innovation through commercialization—they are more comfortable than many Western companies are with putting a new product or service into the market quickly and improving its performance through subsequent generations. It is common for products to launch in a fraction of the time that it would take in more developed markets. While the quality of these early versions may be variable, subsequent ones improve rapidly.1

Chinese companies also benefit from their government’s emphasis on indigenous innovation, underlined in the latest five-year plan. Chinese authorities view innovation as critical both to the domestic economy’s long-term health and to the global competitieness of Chinese companies. China has already created the seeds of 22 Silicon Valley–like innovation hubs within the life sciences and biotech industries. In semiconductors, the government has been consolidating innovation clusters to create centers of manufacturing excellence.

But progress isn’t uniform across industries, and innovation capabilities vary significantly: several basic skills are at best nascent within a typical Chinese enterprise. Pain points include an absence of advanced techniques for understanding—analytically, not just intuitively—what customers really want, corporate cultures that don’t support risk taking, and a scarcity of the sort of internal collaboration that’s essential for developing new ideas.

Multinationals are far stronger in these areas but face other challenges, such as high attrition among talented Chinese nationals that can slow efforts to create local innovation centers. Indeed, the contrasting capabilities of domestic and multinational players, along with the still-unsettled state of intellectual-property protection (see sidebar, “Improving the patent process”), create the potential for topsy-turvy competition, creative partnerships, and rapid change. This article seeks to lay out the current landscape for would-be innovators and to describe some of the priorities for domestic and multinational companies that hope to thrive it.

China’s innovation landscape

Considerable innovation is occurring in China in both the business- to-consumer and business-to-business sectors. Although breakthroughs in either space generally go unrecognized by the broader global public, many multinational B2B competitors are acutely aware of the innovative strides the Chinese are making in sectors such as communications equipment and alternative energy. Interestingly, even as multinationals struggle to cope with Chinese innovation in some areas, they seem to be holding their own in others.

The business-to-consumer visibility gap

When European and US consumers think about what China makes, they reflexively turn to basic items such as textiles and toys, not necessarily the most innovative products and rarely associated with brand names. In fact, though, much product innovation in China stays there. A visit to a shop of the Suning Appliance chain, the large Chinese consumer electronics retailer, is telling. There, you might find an Android-enabled television complete with an integrated Internet-browsing capability and preloaded apps that take users straight to some of the most popular Chinese Web sites and digital movie-streaming services. Even the picture quality and industrial design are comparable to those of high-end televisions from South Korean competitors.

We observe the same home-grown innovation in business models. Look, for example, at the online sector, especially Tencent’s QQ instant-messaging service and the Sina Corporation’s microblog, Weibo. These models, unique to China, are generating revenue and growing in ways that have not been duplicated anywhere in the world. QQ’s low, flat-rate pricing and active marketplace for online games generate tremendous value from hundreds of millions of Chinese users.

What’s keeping innovative products and business models confined to China? In general, its market is so large that domestic companies have little incentive to adapt successful products for sale abroad. In many cases, the skills and capabilities of these companies are oriented toward the domestic market, so even if they want to expand globally, they face high hurdles. Many senior executives, for example, are uncomfortable doing business outside their own geography and language. Furthermore, the success of many Chinese models depends on local resources—for example, lower-cost labor, inexpensive land, and access to capital or intellectual property—that are difficult to replicate elsewhere. Take the case of mobile handsets: most Chinese manufacturers would be subject to significant intellectual property–driven licensing fees if they sold their products outside China.

Successes in business to business

Several Chinese B2B sectors are establishing a track record of innovation domestically and globally. The Chinese communications equipment industry, for instance, is a peer of developed-world companies in quality. Market acceptance has expanded well beyond the historical presence in emerging markets to include Europe’s most demanding customers, such as France Télécom and Vodafone.

Pharmaceuticals are another area where China has made big strides. In the 1980s and 1990s, the country was a bit player in the discovery of new chemical entities. By the next decade, however, China’s sophistication had grown dramatically. More than 20 chemical compounds discovered and developed in China are currently undergoing clinical trials.

China’s solar- and wind-power industries are also taking center stage. The country will become the world’s largest market for renewable-energy technology, and it already has some of the sector’s biggest companies, providing critical components for the industry globally. Chinese companies not only enjoy scale advantages but also, in the case of solar, use new manufacturing techniques to improve the efficiency of solar panels.

Success in B2B innovation has benefited greatly from friendly government policies, such as establishing market access barriers; influencing the nature of cross-border collaborations by setting intellectual-property requirements in electric vehicles, high-speed trains, and other segments; and creating domestic-purchasing policies that favor Chinese-made goods and services. Many view these policies as loading the dice in favor of Chinese companies, but multinationals should be prepared for their continued enforcement.

Despite recent setbacks, an interesting example of how the Chinese government has moved to build an industry comes from high-speed rail. Before 2004, China’s efforts to develop it had limited success. Since then, a mix of two policies—encouraging technology transfer from multinationals (in return for market access) and a coordinated R&D-investment effort—has helped China Railways’ high-speed trains to dominate the local industry. The multinationals’ revenue in this sector has remained largely unchanged since the early 2000s.

But it is too simplistic to claim that government support is the only reason China has had some B2B success. The strength of the country’s scientific and technical talent is growing, and local companies increasingly bring real capabilities to the table. What’s more, a number of government-supported innovation efforts have not been successful. Some notable examples include attempts to develop an indigenous 3G telecommunications protocol called TDS-CDMA and to replace the global Wi-Fi standard with a China-only Internet security protocol, WAPI.

Advantage, multinationals?

Simultaneously, multinationals have been shaping China’s innovation landscape by leveraging global assets. Consider, for example, the joint venture between General Motors and the Shanghai Automotive Industry Corporation, which adapted a US minivan (Buick’s GL8) for use in the Chinese market and more recently introduced a version developed in China, for China. The model has proved hugely popular among executives.

In fact, the market for vehicles powered by internal-combustion engines remains dominated by multinationals, despite significant incentives and encouragement from the Chinese government, which had hoped that some domestic automakers would emerge as leaders by now. The continued strength of multinationals indicates how hard it is to break through in industries with 40 or 50 years of intellectual capital. Transferring the skills needed to design and manufacture complex engineering systems has proved a significant challenge requiring mentorship, the right culture, and time.

We are seeing the emergence of similar challenges in electric vehicles, where early indications suggest that the balance is swinging toward the multinationals because of superior product quality. By relying less on purely indigenous innovation, China is trying to make sure the electric-vehicle story has an ending different from that of its telecommunications protocol efforts. The government’s stated aspiration of having more than five million plug-in hybrid and battery electric vehicles on the road by 2020 is heavily supported by a mix of extensive subsidies and tax incentives for local companies, combined with strict market access rules for foreign companies and the creation of new revenue pools through government and public fleet-purchase programs. But the subsidies and incentives may not be enough to overcome the technical challenges of learning to build these vehicles, particularly if multinationals decline to invest with local companies.

Four priorities for innovators in China

There’s no magic formula for innovation—and that goes doubly for China, where the challenges and opportunities facing domestic and multinational players are so different. Some of the priorities we describe here, such as instilling a culture of risk taking and learning, are more pressing for Chinese companies. Others, such as retaining local talent, may be harder for multinationals. Collectively, these priorities include some of the critical variables that will influence which companies lead China’s innovation revolution and how far it goes.

Deeply understanding Chinese customers

Alibaba’s Web-based trading platform, Taobao, is a great example of a product that emerged from deep insights into how customers were underserved and their inability to connect with suppliers, as well as a sophisticated understanding of the Chinese banking system. This dominant marketplace enables thousands of Chinese manufacturers to find and transact with potential customers directly. What looks like a straightforward eBay-like trading platform actually embeds numerous significant innovations to support these transactions, such as an ability to facilitate electronic fund transfers and to account for idiosyncrasies in the national banking system. Taobao wouldn’t have happened without Alibaba’s deep, analytically driven understanding of customers.

Few Chinese companies have the systematic ability to develop a deep understanding of customers’ problems. Domestic players have traditionally had a manufacturing-led focus on reapplying existing business models to deliver products for fast-growing markets. These “push” models will find it increasingly hard to unlock pockets of profitable growth. Shifting from delivery to creation requires more local research and development, as well as the nurturing of more market-driven organizations that can combine insights into detailed Chinese customer preferences with a clear sense of how the local business environment is evolving. Requirements include both research techniques relevant to China and people with the experience to draw out actionable customer insights.

Many multinationals have these capabilities, but unless they have been operating in China for some years, they may well lack the domestic-market knowledge or relationships needed to apply them effectively. The solution—building a true domestic Chinese presence rather than an outpost—sounds obvious, but it’s difficult to carry out without commitment from the top. Too many companies fail by using “fly over” management. But some multinationals appear to be investing the necessary resources; for example, we recently met (separately) with top executives of two big industrial companies who were being transferred from the West to run global R&D organizations from Shanghai. The idea is to be closer to Chinese customers and the network of institutions and universities from which multinationals source talent.

Retaining local talent

China’s universities graduate more than 10,000 science PhDs each year, and increasing numbers of Chinese scientists working overseas are returning home. Multinationals in particular are struggling to tap this inflow of researchers and managers. A recent survey by the executive-recruiting firm Heidrick & Struggles found that 77 percent of the senior executives from multinational companies responding say they have difficulty attracting managers in China, while 91 percent regard employee turnover as their top talent challenge.

Retention is more of an issue for multinationals than for domestic companies, but as big foreign players raise their game, so must local ones. Chinese companies, for example, excel at creating a community-like environment to build loyalty to the institution. That helps keep some employees in place when competing offers arise, but it may not always be enough.

Talented Chinese employees increasingly recognize the benefits of being associated with a well-known foreign brand and like the mentorship and training that foreign companies can provide. So multinationals that commit themselves to developing meaningful career paths for Chinese employees should have a chance in the growing fight with their Chinese competitors for R&D talent. Initiatives might include in-house training courses or apprenticeship programs, perhaps with local universities. General Motors sponsors projects in which professors and engineering departments at leading universities research issues of interest to the automaker. That helps it to develop closer relations with the institutions from which it recruits and to train students before they graduate.

Some multinationals energize Chinese engineers by shifting their roles from serving as capacity in a support of existing global programs to contributing significantly to new innovation thrusts, often aimed at the local market. This approach, increasingly common in the pharma industry, may hold lessons for other kinds of multinationals that have established R&D or innovation centers in China in recent years. The keys to success include a clear objective— for instance, will activity support global programs or develop China-for-China innovations?—and a clear plan for attracting and retaining the talent needed to staff such centers. Too often, we visit impressive R&D facilities, stocked with the latest equipment, that are almost empty because staffing them has proved difficult.

Instilling a culture of risk taking

Failure is a required element of innovation, but it isn’t the norm in China, where a culture of obedience and adherence to rules prevails in most companies. Breaking or even bending them is not expected and rarely tolerated. To combat these attitudes, companies must find ways to make initiative taking more acceptable and better rewarded.

One approach we found, in a leading solar company, was to transfer risk from individual innovators to teams. Shared accountability and community support made increased risk taking and experimentation safer. The company has used these “innovation work groups” to develop everything from more efficient battery technology to new manufacturing processes. Team-based approaches also have proved effective for some multinationals trying to stimulate initiative taking .

How fast a culture of innovation takes off varies by industry. We see a much more rapid evolution toward the approach of Western companies in the way Chinese high-tech enterprises learn from their customers and how they apply that learning to create new products made for China. That approach is much less common at state-owned enterprises, since they are held back by hierarchical, benchmark-driven cultures.

Promoting collaboration

One area where multinationals currently have an edge is promoting collaboration and the internal collision of ideas, which can yield surprising new insights and business opportunities. In many Chinese companies, traditional organizational and cultural barriers inhibit such exchanges.

Although a lot of these companies have become more professional and adept at delivering products in large volumes, their ability to scale up an organization that can work collaboratively has not kept pace. Their rigorous, linear processes for bringing new products to market ensure rapid commercialization but create too many hand-offs where insights are lost and trade-offs for efficiency are promoted.

One Chinese consumer electronics company has repeatedly tried to improve the way it innovates. Senior management has called for new ideas and sponsored efforts to create new best-in-class processes, while junior engineers have designed high-quality prototypes. Yet the end result continues to be largely undifferentiated, incremental improvements. The biggest reason appears to be a lack of cross-company collaboration and a reliance on processes designed to build and reinforce scale in manufacturing. In effect, the technical and commercial sides of the business don’t cooperate in a way that would allow some potentially winning ideas to reach the market. As Chinese organizations mature, stories like this one may become rarer.

China hasn’t yet experienced a true innovation revolution. It will need time to evolve from a country of incremental innovation based on technology transfers to one where breakthrough innovation is common. The government will play a powerful role in that process, but ultimately it will be the actions of domestic companies and multinationals that dictate the pace of change—and determine who leads it.

David Griffith’s Note: I went to the US-China Economic Forum yesterday in downtown Los Angeles as a guest of the Chinese Consul General to get a glimpse of the future Chinese leader, Xi Jinping, and I was encouraged by what I saw. Xi appears to be a man who likes America and can in turn put a new face on China that Americans will embrace. The American leaders there, Vice President Joe Biden, Governor Jerry Brown, and Mayor Antonio Villaraigosa looked very comfortable with the future president and their various counterparts from Chinese government at both the national and provincial levels. Over 500 Chinese companies were part of a series of major trade announcements. The event definitely confirms Southern California’s prominence in trade with China.

LOS ANGELES (Reuters) – China’s leader-in-waiting Xi Jinping on Friday swiped away fears that his country’s economic growth could stumble, and turned to courting American companies, film-makers and governors hungry for a slice of that growth on the final day of his U.S. visit.

At the end of Vice President Xi’s five-day trip, his U.S. counterpartJoe Biden announced China had agreed to make it easier for Hollywood to distribute movies to China’s expanding audiences. Xi (pronounced “shee”) told a business forum in Los Angeles that China would promote greater domestic demand and turn more to the United States to buy imports and send investment.

Despite recent economic slowing and persistent price pressures, Xi told the gathered business executives that China’s economic momentum would not falter as some economists warn.

“China’s economy will maintain stable growth,” he said “There will be no so-called hard landing.”

Xi is almost sure to succeed Hu Jintao as Chinese president in just over a year, and the final day of his tour of the United States featured commercial deals and reassuring talk intended to blunt American ire about the trade gap between the countries.

“We will further increase imports from other countries in the light of our economic and social development and consumer demand. We will actively expand imports from the United States,” Xi later told a midday meeting.

Biden, who accompanied Xi to Los Angeles, praised the Chinese Vice President‘s efforts to reach out to often wary Americans, but reminded him that rancor over trade imbalances and barriers had not evaporated in all the sunny goodwill.

“The crux of our discussion is that competition can only benefit everyone if the rules are fair and followed,” Biden told the midday reception for Xi.

The U.S. movie industry has long complained about China’s restrictions on the number of foreign films allowed into the country each year, a limit that they say boosts demand for the bootleg DVDs that are widely available in China.

The film announcement does not remove China’s quota system, but it might ease some of the ire.

The agreement allows more American exports to China of 3D, IMAX, and enhanced-format movies, and also expands opportunities to distribute films through private enterprises rather than the state film monopoly, the U.S. Trade Representative’s office said.

GETTING READY FOR NEXT DECADE

The two vice presidents both suggested that Xi’s diplomacy, deals and folksy public displays could pave the way for steadier ties between the world’s two biggest economies.

Xi said that he felt from his visit that “mainstream American opinion” supports stronger ties. “I can now say that my visit has been fully successful,” he said.

“We’ve established a personal friendship and a healthy working relationship,” he said of himself and Biden.

Xi is poised to become China’s next leader after a decade in which it has grown to become the world’s second-largest economy. Beijing wants to avoid tension with Washington while the Communist Party leaders focus on the power handover.

Xi’s visit to the United States was also intended to get both sides more familiar with each other for the decade that he could be in power. He will most likely succeed Hu Jintao as party chief in late 2012 and as president in early 2013.

Under Xi, China’s economic size and military capabilities are likely to grow closer to U.S. levels.

Washington and Beijing have often jostled over economic, political and foreign policy disputes from human rights to Taiwan and most recently Syria.

The U.S. trade deficit with China expanded to a record $295.5 billion in 2011, and many U.S. lawmakers complain China’s yuan currency is significantly undervalued, giving its companies an unfair advantage.

The Obama administration has also accused China of distorting trade flows by ignoring intellectual property theft, putting up barriers to foreign investors and creating rules that favor China’s state-owned behemoths.

Xi’s stop in Los Angeles was choreographed to blunt those complaints and make China’s case that its rapid growth presents the U.S. economy with opportunities, not threats.

Scores of executives from major U.S. and Chinese companies, from Intel to Microsoft, lined up to sign deals after Xi’s address at the economic forum on Friday.

They included “Kung Fu Panda” studio Dreamworks Animation’s venture to make films from Shanghai, and Chinese telecom giant Huawei’s pledge to award $6 billion in contracts over three years to Qualcomm Inc, Broadcom Corp and Avago.

“MISSION IMPOSSIBLE” FAN

More than the publicly stern Chinese President Hu, Xi has tried to put a friendlier face on his government during his U.S. visit, including revisiting the small town of Muscatine in Iowa where he visited in 1985 and stayed two nights with a family.

The 58-year-old also visited the International Studies Learning School in South Gate — a Los Angeles enclave of mainly Hispanics — where students learn Chinese.

At the school, Xi recalled his first visit to Muscatine: “They gave me the same impression that, like Chinese people, they are warm-hearted, friendly, honest and hard-working. Twenty-seven years have passed, but that remains my impression, and it has become a deeper one.”

Xi also offered a glimpse of his personal life, telling the students he enjoyed swimming and watching sports, including American basketball, baseball and gridiron football.

Showing his familiarity with Hollywood fare, Xi said it was difficult to find time to relax. “It’s like the name of that American movie — ‘Mission Impossible’.”

After their visit to the school, Biden told reporters the talks with Xi had been very forthright, and was also intensely curious about the workings of the American political system.

“This is a guy who wants to feel it and taste it, and he’s prepared to show another side of Chinese leadership,” said Biden. “He is intensely interested in understanding why we think the way we do, what our positions are, and the need to actually broaden this kind of understanding.”

Xi was due to watch part of an LA Lakers basketball game before he left for the next two countries of his international tour, Ireland and then Turkey.

David Griffith’s Note: I recently published the case for a Chinese ‘soft landing’ in this blog. There are many ‘China Bears’ that are now advocating that the Chinese economy is becoming the classic bubble; while I don’t necessarily agree with this belief, and hope for the sake of the global economy they’re wrong, here’s one excellent argument for the bearish side.

SEEKING ALPHA by: Williams Equity Analysis December 19, 2011

China’s growth curve has gone parabolic in recent years. For the last couple of decades, China has typically averaged 10% GDP growth, and it has maintained that growth even as a multi-trillion dollar economy. Of course, 10% growth in an economy already worth trillions is an astounding achievement, but it can also lead to severe economic tribulations, such as soaring housing and food prices. China has incurred both of these troubles. As a growing middle class emerges, demand for beef has far outstripped supply growth, and beef is typically making record highs every month. Additionally, the usage of real estate as collateral for local government loans, amongst other factors, has led to soaring housing prices.

China has a significant housing bubble on its hands. Growth in the real estate sector is important in all modern economies. Construction of homes and commercial office space is a huge driver for demand in the steel, cement, and construction sectors, and is an important part of demand in the commodities market. Construction requires the use of iron (in steel), copper, and fuel. Moreover, local governments depend wholly on rising land and real estate prices, since almost all of their collateral is in their properties. The famously investment driven Chinese also depend heavily on rising home prices to attain better rates of return than are possible in other markets.

A slowdown in the real estate market has appeared recently; prices in nine major Chinese cities fell 4.9% in April from a year earlier. Real estate prices in major cities had been on an absolute tear for the past several years, as a growing Chinese middle class desires to migrate from the countryside into major cities. A year ago, prices in these cities rose an astounding 21.5%. Now, as demand has significantly weakened, some analysts believe the supply glut in two of China’s largest markets (Dalian and Tianjin) could be as bad as twenty months of housing inventory. Furthermore, China’s official numbers need to be taken with a grain of salt, since the central government can twist the numbers a bit; the government can pressure developers to withhold or add high-value properties, contingent on the kind of statistics it wants to display. Therefore, China’s housing slowdown is potentially being understated.

Ordinary citizens are finding it nearly impossible to buy a reasonably priced home in Chinese cities, which is a classic sign of a housing bubble. When average, financially sound individuals can no longer buy homes, prices have typically deviated far away from their equilibriums. In 2006, it cost $100,000 to buy a decent apartment in Beijing. The average Chinese citizen would have had to save for 32 years based on the average disposable income. Five years later, in 2011, it cost $250,000. Of course, the actual price of housing is irrelevant if incomes are rising as much, if not more than housing prices are growing. Unfortunately for Chinese citizens, income growth came up short, and it now takes more than 57 years of saving to be able to cover the cost of buying said apartment. 57 years of saving is not a normal figure for average citizens in a healthy, economically balanced real estate market. Even the chairman of China Construction Bank, one of China’s largest banks (and who is heavily dependent on strong real estate growth) said, “In some ways, real-estate prices are really crazy.”

Housing prices got to this level mainly because the Chinese government wanted its citizens to save, but it has not offered them viable alternatives to the real estate market in which to invest. As previously mentioned, the stock market has been too volatile for most individual investors, capital markets are considered to be overwhelmingly underdeveloped, and the deposit rates that banks are paying their customers are much too low to provide reasonable rates of return after inflation is factored in. Thus, citizens have had no other practical investment vehicles in which to park their savings. China has, in recent years, attempted to cool the real estate market, most notably by requiring that prospective buyers put 40% down in cash on their purchases. Even more recently, that mandate was bumped up to 60% down. There will, at the very least, be an assuredly long-term trend of deflating construction activity and declining housing prices. This development will lead to lower GDP growth.

Fitch, another one of the “big three” rating agencies, also put out a terrifying note: “the process of bundling the debts into securities continues to grow, which is transferring the credit risk to a broad group of investors.” What this process essentially describes is securitization; any hint of the word should spook those familiar with the 2008 financial crisis. These banks are wrapping up bad loans and selling them to outside investors in return for a sum of cash. Investors can typically bet on different tranches of the security; the tranches with the highest probability have the lowest rate of return for the investor, and as you move into riskier tranches, the rate of return improves (providing that the default limit is not reached). Chinese regulators are considering allowing banks to further securitize more of their assets, in order to reduce liquidity and capital strains (by generating more cash flow). This should come as unwelcomed news, and it appears that the central government is becoming worried about the low-quality loans that are maturing in the short term.

Increased leverage in China is a dangerous development. Worldwide, overwhelming debt levels, particularly in developed economies, have been a major economic concern recently; China is typically (and mistakenly) not included in these discussions relating to over-leveraged economies. The ability of the Chinese economy to expand right on through the global recession at a torrid pace was baffling. The Chinese Gross Domestic Product grew at 9.6% in 2008, 9.2% in 2009, and 10.3% in 2010. This expansion, compared with the figures in the European Union and the United States, whose economies saw negligible growth in 2008, contraction in 2009, and about 2% growth in 2010, shows a stark contrast. The obvious question, of course, is how it is possible that China grew an incredible 9.2% in 2009, while two of its biggest customers were plummeting into their worst recessions in decades. The answer lies within massive, hidden government expenditures.

Chinese exports make up 30% of the nation’s GDP, so any decline in total annual exports should result in a subsequent decline in GDP growth, everything else equal. In 2009, China’s global exports fell 16% from 2008, yet its GDP mustered 9.2% growth. This kind of growth in a multi-trillion dollar economy is difficult enough, without the added hurdle of severe demand contraction in overseas markets. In order to pick up the slack, consumer spending (domestic consumption) had to have either surged, or the government must have had to sink hundreds of billions, or even trillions into the Chinese economy to achieve 9.2% growth. Total household consumption is typically used to measure domestic consumption. Chinese household consumption checked in at 35% of GDP in 2008 and 35.1% of GDP in 2009. This negligible growth is clearly not enough to make up for a $230 billion decline in exports; the only driver of growth left is government spending. Not surprisingly, the World Bank calculated that while fixed-asset investments (the definitive measure of social capital investments and government real estate projects) were only responsible for 4.6% of China’s GDP growth in 2008, they were responsible for 8.8% of GDP growth in 2009; this was good for a 91% year-over-year increase. This investment is now equal to 70% of China’s GDP. To put this figure in perspective, Japan’s fixed-asset investment was equivalent to approximately 35% in the 1980s (during its housing boom), and the United States’ measurement has typically hung around 20% for the last couple of decades.

Certainly, China needs to allocate significant capital toward infrastructure; China has a massive population, a furiously growing middle class, and a great deal of migration from rural areas into major cities. The issue, however, is that much of this investment is highly leveraged (little cash is put down as payment, while the rest is financed through bank loans), and a large proportion of these projects exist simply to sustain headline growth over 9%, despite deteriorating fundamentals. Because these projects are so leveraged, merely servicing the debt becomes a huge intermediate-term cost. Beijing’s public finance system is set up so that local governments are responsible for almost all social services, which include social capital and real estate investments, even though the central government collects 60% of all national taxes. Because of this, local governments have almost no equity to finance projects, even while Beijing is mandating increased investment to sustain rapid headline growth, as written in the 2008 national stimulus bill. Worse still, local governments aren’t even allowed to sell bonds to institutional or private investors to help pay for the projects; a typical solution is to create state-run corporations to whom private banks will then lend money to, thereby serving as the intermediary.

To make the system even risker and more confusing, the collateral that the local governments and their subsidiaries often use to attain the bank loans is lofty, and likely overvalued land prices. Finally, in confusing and illogical fashion, private banks aren’t even allowed to collect on bad loans, or any loan for that matter. Essentially, money lent to state enterprises is free. Of course, private banks have trillions in consumer deposit monies, so a growth in asset toxicity, or bad loans, would require huge recapitalizations from the Chinese federal government, or a financial crisis could ensue.

Furthermore, Beijing’s tight controls have resulted in a structure in which bank loans are the only way to finance public projects. Since local governments collect almost no tax revenue (the central government collects 60% of all taxes), they can’t use cash to fund capital ventures. Also, as previously discussed, since local governments can’t issue bonds, they must go to private banks to get the necessary principal; their only collateral for the loans is state-owned real estate. This has inexorably led to unquantifiable risk for banks, local governments, and the central government (since Beijing will have to bail-out involved parties if and when the loans go rotten). Land-grabs have become common in China (government authorities seizing private property in order to generate revenue), a sure sign of deteriorating conditions.

Moreover, Chinese officials have a destructive propensity for attempting to distort underlying demand by pumping up spending, and then hiding it in state-run investment corporations. To see figures that show severe exports contraction and stagnant domestic consumption, in conjunction with 9.2% GDP growth in 2009 screams falsification and distortion to me. I also believe that China’s tendency to re-stimulate its economy every time international demand weakens is a horrible way to try and achieve sustainable long-term growth.

Given these factors, it appears certain that most investors have yet to grasp a firm understanding of both how secretive and manipulative the Chinese Government is, and how much debt is hidden in the system. Additionally, a horrific financial structure will be a major factor in China’s eventual crash landing.

This shouldn’t be surprising to anyone. The idea that a few government officials can decide how an economy should function, and consequently set countless controls on markets is remarkably ignorant. Perhaps the most important thing to note is that the Chinese governemnt is desperate to keep GDP growing at a pace above at least 7% for the next several years, since China requires astonishing expansion to mitigate the effects of a rapid migration into cities. The political pressures alone will almost certainly lead to poor decision making (over-aggressive stimulus), and an eventual uprising from the Chinese people. There is simply no way that a wealthier, more educated China will remain quiet (they’ve already begun protesting) about a suppressive system.

While sheltered from discussions involving the failed Keynesian practices of incredibly over-leveraged developed economies, China is indeed the younger brother of countries like the U.S. and the European Union.

What Should Investors be Doing?

Investors need to understand that China’s days as “the driver of World growth” are numbered. No, that doesn’t mean China will fall off a cliff tomorrow, but it’s coming. All it takes is one serious catalyst; it could be Europe, angry Chinese banks, or a continued decline in real estate prices to the point where local governments become insolvent.

At the very least, investors should know how much prospective investments rely on Chinese growth. Companies like Intel (INTC) derive half of their revenue from the region. You can also play the short side of companies who are heavily reliant on Chinese growth, but this complicates the process a bit and may not provide the exposure you’re looking for.

Conclusion

As was the case in the years leading up to the 2008 global economic collapse, the so-called “China bears” are often brushed aside as doom and gloomers. General consensus is that China can engineer a soft-landing, so as to avoid to a rapid decline in economic activity.

Well, for those in that camp, let me ask you something. Why would you ever want to turn off good economic growth? Healthy, natural economic advances should never be thwarted by governments or central banks. The only reason growth would ever need to be turned off artificially, i.e. by a central authority, is because it has bubbled so much that further growth would cause a catastrophe.

Granted, as an economy surges, any free market should begin to inch interest rates higher anyway. The issue in Beijing is that the time to decrease speculative activity was before it saw housing prices reach epic levels, or before it saw food prices begin to cause street riots. At this point, any central action is too late. A horrificially constructed financial system, in conjunction with overly agressive central planning, has set China up for anything but a soft-landing.